–  MAY 2018 INSIGHTS BY THE CURVE TEAM –

Highlights

  • The RBA left the cash rate on hold again in May and continues to see a gradual move towards achieving its forecasts over the medium term.
  • Short term rates have eased back over the past week; however, the yield curve continues to steepen.
  • There is a growing consensus that from a global perspective inflation is on its way back.
  • Risks to the domestic outlook remain skewed to the downside, suggesting any change to the cash rate is some way off.

Rates Recap

  • The RBA left the cash rate on hold again in May with the cash rate remaining at 1.50% since August 2016.
  • Markets pricing continues to suggest the next move in the cash rate will be up but expectations have been pushed out to August 2019.
  • Short end pressure on rates has eased with BBSW pulling back in recent days.
  • The long end of the curve continues to rise, tracking moves in global markets, leaving the yield curve steeper.
  • The Fed remains the only central bank looking to lift rates in the near term, with the debate over how many more are to come this year still raging.

Is Inflation Finally Coming?

Inflation might finally be arriving if the latest updates from a couple of central banks is anything to go by. It has been something that has been widely expected for some time and even as unemployment rates reach new lows in a number of countries, a meaningful uptick in inflation has so far proved to be elusive.

In last Friday’s Quarterly Statement on Monetary Policy, the RBA devoted quite a bit of column space to commentary around the international environment, especially the global inflation outlook.

The key line from the RBA’s commentary on global inflation was that “although inflation generally remains low, increasing capacity pressures in product and labour markets are expected to add to inflationary pressures”. 

When you take a look through the large range of charts and statistics they use to draw their conclusion, it is a sound argument. The RBA pointed to the duration of the economic recovery since the depths of the GFC and the eroding of spare capacity. More specifically, the RBA said:

“As the recovery has continued, spare capacity in the major advanced economies has been absorbed: output gaps are now estimated to have closed or turned positive (Graph 1.6). Together with other measures, such as capacity utilisation and supplier delivery times, this suggests that capacity constraints are increasing.”

In addition to capacity constraints, employments statistics across a number of major developed economies are the strongest they have been in decades. The combination of record low unemployment rates and capacity constraints suggest it is a matter of when, not if, inflation finally announces itself.

The US Federal Reserve appears to be on the same page. There was a number of suggestions last week that they expect inflation to pick up in the near term. While they left the Fed Funds Rate on hold when they met last week, they did introduce a new word to their accompanying statement which certainly got the markets attention.

“inflation on a 12-month basis is expected to run near the Committee’s symmetric 2 percent objective over the medium term.” In assessing the outlook in terms of its impact on the setting of monetary policy, the statement then added “The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal.”

Incoming Deputy Chair John Williams went one step further to clarify what the Fed meant by symmetric when speaking last Friday. Williams said that “I am personally comfortable with the fact that inflation may overshoot that 2 percent for a while.” He then added that the word symmetric was “a signal to say that inflation will sometimes be above, sometimes below, but on average at 2 percent”.

It could just be coincidence or a sign of confidence that inflation is finally about to eclipse their 2% target level in the months ahead. Either way, it was their way of pointing out to the market that they won’t be rushed into accelerating their interest rate normalisation schedule should it rise above 2%.

Joining all the dots it suggests inflation might finally be ready to announce itself on the global stage after remaining painstakingly low for a very long time.

Outlook for Interest Rates

Increasing expectations of rising inflation offshore are yet to permeate through to the domestic outlook. While the RBA sees inflation rising in a number of other developed nations, it made no material changes to its economic outlook in its latest Quarterly Statement on Monetary Policy.

Over the medium term, the RBA’s forecasts in the May statement were little changed from those seen in the February statement. After doubt was cast over the growth forecasts a month ago after they removed to reference to above 3% growth, the forecasts still see growth at or above 3% over the forecast period.

The key word when it came to the RBA’s outlook, especially when it comes to inflation, was ‘gradual’. The RBA sees a number of moving pieces within the economy that will continue to shift slowly, eventually resulting in the pick up in growth and thus inflation.

The key to their outlook continues to be business investment, growing exports and infrastructure spending will eventually eat away at the spare capacity in the employment market. Once this gathers pace, it should then stimulate wage growth and in turn lift inflation.

It is the balance of these risks to the outlook which will eventually determine the direction and timing of the next move in interest rates. At the moment the RBA sees plenty of risks and outlined them in their statement:

  • Domestically, there is uncertainty about the degree of spare capacity in the labour market and how this might translate into inflationary pressures
  • The outlook for consumption growth is also affected by uncertainty about the outlook for income growth and the high level of household debt
  • Risks remain in the global economy that could affect trade
  • Global inflation could be higher than expected

At the moment the market is expecting the next move to be up but not until August 2019.  How the risk above evolves will shape the outlook for interest rates; however, the key remains the wages and the consumer and until both of these are on more solid footing, the cash rate is unlikely to be going anywhere.

Australian Economic Highlights

  • Growth for Q4 came in at 0.4%, short of both the market and RBA’s expectations. The economy grew just 0.4% in Q4 which saw the annual rate slow to 2.4% from an upwardly revised 2.9% last quarter.
  • CPI was largely in line with estimates in the first quarter. While the annual rate of headline inflation was unchanged, the core rate edged higher thanks to revisions to previous quarters. It has the RBA suggesting core inflation has bottomed for this cycle.
  • Employment data has slowed rather dramatically the past two months. Total employment was up 4,900 in March while February’s gain of 17,500 was revised to a decline of 6,300. The unemployment rate remained stable at 5.5% thanks to a fall in the participation rate. 
  • The weakness in the ANZ job ads report continued for a third straight month. Falls for the past three months are at odds with the NAB business survey employment index which is hovering near a record high.
  • The NAB business conditions bounced back equal its record high going back to 1997 with the index at 21. The Business confidence also improved with the index rising to 10, above its long run average of 6. Wage and cost pressures remain absent according to the survey. 
  • Consumer confidence slipped a little in April but managed to hold above the key 100 level. Family finances continue to prove a drag on the index which remains well below the 105-115 level, typically associated with a robust consumer.
  • The February bounce in Retail sales was short lived with sales flat in March and falling 0.5% excluding food. The result dragged down the quarterly performance with sales ex-inflation only 0.2% in Q1.
  • Housing finance remained stable again in February. Headwinds to housing finance are growing as negative headlines from the Royal Commission increase the push for tighter lending standards while funding costs continue to rise.  
  • Australia’s trade balance has gone from strength to strength throughout the first quarter. After solid results in January and February, the trade surplus rose to $1.5bln in March. Net exports are expected to boost growth in the first quarter.
  • Following large swings in Building approvals as high density approvals rise and fall each month, total approvals were more stable in March. Approvals rose 2.6% to be 14.5% higher than a year ago but remain 10% below the 2015-16 peak.
David Flanagan

David Flanagan

Director Interest Rate Markets